Is capitalism finished or has it just caught a nasty cold? This series of articles will argue the case for a different style of capitalism.

Thursday, 27 August 2009

Cracking the Bonus Culture - Why Regulation cannot be the answer

Yesterday Lord Turner, Chairman of the Financial Services Authority proposed a tax on financial services transactions as a means of curbing excessive pay in the sector.He said that the financial sector had grown “beyond a reasonable size” and accounted for too much of British output."I think some of it is socially useless activity," said Lord Turner, referring to the complex financial instruments that have largely been blamed for triggering the biggest global financial crisis in decades.

Whilst a relatively radical set of ideas, especially compared to Alistair Darling who is still “considering legislation”, this is just the latest utterance on the subject.The general opinion is that one way or the other the financial sector globally is going to be more tightly regulated.What is less certain is what form this regulation should take and how it can be applied and policed globally.

However our view is that if Capitalism, whether in the City or elsewhere is to prosper again, it will not be through Regulation.Wherever there are rules, there will be opportunities for the unscrupulous to explore the fringes of definition, structure and enforcement.Wherever there is wealth, you will find the unscrupulous “lingering with intent”, as they used to say.

They lingered long enough and close enough to take over much of the management of wealth and to wrap it all up in a bedazzling miasma of complexity and mis-direction.The Magic Circle should have been reeling in envy of these conjurors.They cannot be regulated; they must be eliminated, made unable to function.

The potential for Capitalism to return to its former strength in the future will depend on Ethics – on the development and maintenance of Trust between individual stakeholders.And, trust is the outcome of inter-personal relationships and transactions – it is earned by doing, not by promising nor, least of all, by certification or regulation.And here we have the essence of the new future – a return to people dealing with people and trading based solely on tangible assets, and credit based on the lenders’ personal guarantees - the Restoration of Trust.And nowhere is this needed more than in the Banking sector and The City.

The Restoration of Trust

In order for this to be possible, much will have to change.Will monolithic centralised organisations be unable to do business this way and be required to change how they operate?Will decision making only between principals with local responsibility, local accountability and local authority become the norm?Will large organisations be able to bring themselves to expect and allow local individuals to take risks?Will financiers and lenders be able to adapt to the idea of actually holding personal title to the commodities and assets with which they seek to trade?Will the principles of mutuality become much more widespread and overlap into the business to business commercial arrangements and relationships? Will performance related rewards reflect both gains and losses over extended time spans, or is this just trivial tinkering with a symptom?

How might we reflect this change in the “Global Marketplace”?How might we inhibit or constrain the adverse effects of short term betting that have been so vividly demonstrated? Should short term performance measurement be banned from all performance related reward schemes – and from business accounting public reporting?Should all periodic reporting be required to be historically smoothed?Or will we, again, be putting salve on the symptoms and ignoring the disease?

Control Theory – the solution that has never been considered?

Or should we recognise that these international financial marketplaces are just an enormous collection of massively complex closed loop control systems that are intrinsically unstable?Should we perhaps think about other such mechanisms, such as “Galloping Gertie” the TacomaNarrowsBridge that collapsed spectacularly in 1940, or a motor car rendered uncontrollable by failed shock absorbers, or the ear piercing shriek of microphone feedback in a public address system?All engineers know that undamped reactions can cause resonance, massive instability leading to self destruction, in all such mechanisms, or systems. Experienced control engineers know too that relatively tiny energy inputs are enough to stimulate such systems beyond control.

The financialworld is full of such potentially resonating systems, both human based (“market sentiment” - what a phrase) and technological (from Fund Trackers onwards) – and they are all undamped.In 1969, an early experiment in Canada using computer based share trading decisions generated extraordinary returns compared to the “normal” market.A cursory analysis showed that, once more than 2% to 3% of the total market trades became based on such technology, then the overall rate of returns would then converge to that new rate.That was 40 years ago, and the financial world has learned nothing.

If unstable mechanisms and systems are to made stable, they need to be damped – they need to have some of their energy “destroyed” to limit their intrinsic resonant feedback.In mechanical devices, this is often achieved by friction, either mechanical or hydraulic.In electronic systems energy absorption or time delay (e.g. “phase shifting”) commonly perform the role.In human systems, e.g. “market sentiment”, historically the most common source of damping was the elapsed time it took news to travel – even so, this delay was not always enough e.g. the Tulip Boom and the South Sea Bubble.In today’s electronic world, there is no delay at all, everybody knows everything while it is happening.In today’s logical world of semi-automatic systems, there is no systematic damping at all – it is all virtually instantaneous.Market prices swoop and dive, leap and tumble, in reaction to the tiniest of traded volumes and rumours.And, in response, the surrounding human systems cease to be able to cope – there is an almost total loss of confidence - the markets and the economy collapses.

The solution is obvious

Almost certainly too obvious for comfort.The answer to the problem of resonant instability is - Damping.But how might this be achieved practically?Certainly, there is no realistic prospect of converting all the world’s financial market control and analysis systems (even if we knew where they all were) to “add damping”.Nor would “News Management” to delay all news be practicable (bad luck, Gordon). What might happen if we look beyond the systems to the events that are being reported – trading transactions?

What would be the effect of creating a Deal Transaction Completion Delay into all stock, fund and loan deals, everywhere?Since, by our already stipulated requirement that only tangible or personally underwritten, assets might be traded (thus eliminating all derivative trading), only tangible trades would be possible.Perhaps, all such trades would require an elapsed time of 24 hours – instantaneous reaction would become impossible.

This would dampen markets – massively.Additionally, thousands of financial intermediaries would become surplus to requirement removing the distorting effects of their expectations for “compensation”.Enormously complex and opaque financial arrangements would become infinitely more difficult to “engineer”; even fraud might become more difficult, although the pool of less than scrupulous potentially credulous victims will not diminish, nor will the predators disappear.

Local Leadership for World Recovery

Superficially, it appears that total International agreement would be needed for this to be possible – suggesting that the probable feasibility is minimal – although the “opportunities to strut” might appeal to our politicians.Experienced deliverers of effective change know that major transformation of massive and complex systems is not achieved in a single stroke.Effective transformation comes from demonstrated change leadership – and that is best achieved by local, concentrated, and different, actions, behaviours and values that produce different results.

On this basis, we can ask what might happen if just some of the world’s largest markets went this way – e.g. London, New York, Frankfurt and Tokyo?Would they become recognised fairly rapidly as the best places for solid, long term, wealth development?Would that leave the get-rich-quick-regardless-sharks to have their feeding frenzies elsewhere in other, smaller, markets?Would those central stock values be able to resist pricing ripple effects from the shark pools?Would enough “investors” be able to recognise the difference in their risk-to-reward ratios to become more likely to invest in the damped and stable markets rather than the frothing shark pools?

Can we return to the generation of Real Wealth?

Will the stability of a damped market restore the capacity for consistent, long term, wealth increasing, business development by responsible business leaderships?This is a result that would deliver the greatest possible value for all stakeholders, the same form of genuine generation of wealth upon which our Industrial Revolution was first founded.This real wealth generation can be still be seen in many of those innovative market leaders, exhibitors of high Comparative Competitive Strength, that have eschewed public ownership whether through participative proprietors, private shareholders, or through employee ownership.Maybe all our financial markets could become driven by true wealth creation and not by just a tiny incentive reward driven minority of data manipulators.And then, but my hopes are not high, possibly even our Government may focus on actual wealth creation before it is too late.